Can Value-Added Tax Help America Raise Revenues?

Value-added tax, or VAT, is yet another possible tool that government officials have to raise tax revenues. This form of taxation started to become very popular in Western European countries towards the end of the 1960’s. Today, VAT is a common source of tax revenue throughout the European Union and plays an instrumental role in funding many of the social programs on the continent.

Much like retail sales tax, a VAT is an indirect tax, meaning that revenue is collected from someone or some entity other than the person or entity that actually bears the cost of the tax. Unlike a sales tax, which is levied on the total value of an economic exchange, a value-added tax is a tax on all exchanges used in the production process.

Instead of the tax being collected at the cash register by retailers, the money is collected at every point in the production process using one of two methods: Credit-Invoice VAT or Subtraction VAT.

The credit-invoice VAT is similar to a common sales tax. The tax is assessed on the total value of all sales for a business or a consumer. A business can claim a credit if it pays more VAT (buying materials, etc.) then it collects (sales). The subtraction method for assessing VAT focuses on paying a tax on all sales receipts after deducting all monies spent on new investments and the purchase of inputs used in the production process. It is somewhat similar to an income tax return, but does not deduct wages or some types of taxes.

A VAT is similar to a type of national sales tax, where the total tax levied at each stage of the economic supply chain remains a constant fraction of the value added by a business to its products. The real difference between the VAT and a sales tax is that the consumer is unaware of how much of the price of each product is determined by the VAT, which is not the case with sales taxes.

There is a growing momentum in the United States for the addition of a VAT to the tax code. Potential advantages include:

It would help facilitate tax reform and potentially save Social Security and other large entitlement programs by taxing every form of consumption in the market process, which would drastically increase revenues.

It may help reduce the trade deficit by encouraging more domestic production of goods and services because it would be more advantageous to society to produce its own goods when government revenues were raised in the production process. Consumption of foreign-produced goods would only generate revenues at the retail level so more tax revenue would be raised when the goods were domestically produced in a Value-Added Tax system.

While a VAT will certainly add a significant amount of revenue to the public coffers in the short-term, the long-term consequences may create more problems. Some known effects of a VAT after it was implemented in Europe:

Increased cost of government. Nations with a VAT have significantly higher tax burdens than nations without the tax. Nations in Europe began adopting the VAT in the late 1960’s when their tax burden was only slightly higher than the United States. Since adoption of the VAT, nations saw their aggregate tax burden increase by nearly 50% while the US burden had remained relatively stable during the same time period.

Increased income tax rates. In theory, a VAT could replace income taxes if implemented throughout tax system. In practice, however, the VAT has actually been used to increase income taxes as a backdoor means of maintaining distributional neutrality. The effect has been that income taxes in Europe are now higher than they were prior to the implementation of the VAT.

Weakens economic growth in two fundamental ways. First, a VAT effectively diminishes the incentive towards greater productivity because it creates a wedge in-between the pre-tax income and post-tax consumption. Second, a VAT leads to the formation of a larger government. In doing so, more resources are naturally shifted away from the more efficient and productive private sector to the public sector, thus lowering overall economic efficiency.

Currently, the United States does not have any value-added tax but the drive to implement one is gaining momentum. While a VAT would surely add much-needed revenues into the public coffers, the long-term economic impact may lead to a weaker economy, hidden costs, and an even larger and more inefficient government. Unless all income and corporate taxes were eliminated first, a VAT could ultimately add to the aggregate tax burden while diminishing economic efficiency.